How Does
How Does a 401(k) Get Taxed ?
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A 401(k) plan is a retirement plan set up by employers to which employees contribute some of their earnings pre-tax for retirement. Many employers also match their employees' contributions.
Tax Savings and Tax Deferment
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The main feature of a 401(k) plan is that you are making contributions with pretax dollars, which results in tax savings for just putting away money for retirement. Your contributions are therefore tax free. For example, if you earn $50,000 and are taxed at 28%, at the end of the year, you will owe $14,000. if you contribute $5000 to your 401(k), your taxable income is now considered $45,000 and you will now owe $12,600 in taxes - saving $1400 in tax just for contributing to your retirement.
The earnings on your 401(k) are also tax-deferred, which means your nest egg can grow tax-free, and you don't pay any taxes until you start making withdrawals.
Taxation Upon Approved Withdrawals
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Once you have reached age 59 1/2 you are allowed to start withdrawing from your 401(k), and you will be taxed at the current tax rate for your income level. Your withdrawals will be treated as income. Because of this, you are better off contributing to a Roth IRA once you have contributed to the maximum matched by your employer. Since Roth IRAs are after-tax contributions, your future approved withdrawals will be tax free.
Penalty Taxes
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If you withdraw from your 401(k) before you are 59 1/2 or if your reason for an emergency withdrawal does not fall under one of the allowed exceptions, you will have to pay taxes at your current tax rate and be charged a 10% penalty tax. That is why it is not a good idea to borrow against your 401(k). The best way to avoid this is to ensure that you have saved up a 6-month emergency fund to prevent you from dipping into your nest egg.
eHow Article: How Does a 401(k) Get Taxed ?
